Banks prepare for consumer defaults

TimHaran

SAN FRANCISCO (CBS.MW) -- Consumer debt effectively shut down a Chicago-area bank last week, but analysts say most financial institutions are better prepared to handle a growing number of personal bankruptcies and defaults.

"My impression is that banks are in a much stronger position to absorb a rise in problem loans than at times of larger recession," said John Lonski, chief economist at Moody's. "They've set aside reserves for the possibility (of more credit default)."

The American Bankruptcy Institute expects a record 1.5 million people to declare bankruptcy this year. Despite the added risk, banks and credit card companies continue to extend credit, allowing consumers to build up record levels of debt.

"The erosion of credit-card repayment problems hasn't quite peaked yet," Lonski said. "It's a foregone conclusion that the latest upturn in unemployment will lead to more credit-card delinquency and more charge-offs."

Recent Federal Reserve rate cuts have increased the "spread" between what banks are paying for money and what they're charging their customers. Analysts said much of that spread is being added to credit-card issuers' reserves in preparation for more consumer defaults.

Federal regulators took over Hinsdale, Ill.-based Superior Bank last week after finding that careless lending practices to high-risk borrowers cost the Chicago-area savings and loan nearly all of its $2.3 billion in assets.

Superior Bank is the third FDIC-insured failure of the year. The closure is expected to cost the federal insurance fund hundreds of millions of dollars, making it one of the costliest failures ever of a United States financial institution.

Risky business

Unlike most larger banks, Superior was offering credit to high-risk customers. According to the Wall Street Journal, seven of the last 19 bank failures have involved this kind of lending, known as "sub-prime."

"Banks in general are not big in sub-prime lending," said Andrew Collins, an analyst at U.S. Bancorp Piper Jaffray. "There are some that do it, but banks want to go after higher income and safer clients."

At San Francisco-based NextCard
NXCD
which accepts credit-card applications only through its Web site, spokesman Daniel Lemin said careful screening since the company's 1997 launch has kept consumer defaults to a minimum. He said each application passes through an instant analysis involving about 2,000 possible combinations of interest rate and credit limit before offering terms to an applicant.

"It's always been the company's attitude that we'd rather have fewer customers than all the customers in the world that create a higher risk," he said.

Jennifer Scutti, executive director at CIBC World Markets, said credit-card companies minimize their risk by issuing credit more selectively while at the same time keeping a closer eye on existing customers.

"To issue new cards is fine," Scutti said. "People are using credit cards for everyday spending. In prior periods, they were using cash."

She added that Capital One
COF, +0.87%
and MBNA
KRB, +13.07%
are two companies that are succeeding at managing risk by targeting select consumers to "go after the best of the credits" and proactively monitoring current cardholders. CIBC initiated coverage on Tuesday for Capital One at a "strong buy" and MBNA with a "buy" rating.

"Credit-card companies aren't doing themselves a disservice (by continuing to issue credit)," Scutti said. "Card usage is going to continue and for the credit-card companies, it's just a matter of managing risk."

Collins said that banks such as Wells Fargo
WFC, -0.12%
and Citigroup
C, -0.34%
are positioning themselves well to make sure they're not stuck with a mountain of unpaid debt.

"Most large banks understand what's coming in terms of a more difficult consumer environment and many repositioned their card portfolios in the last couple of years," he said. "They've changed their credit limits to be more restrictive, which has meant slower growth in recent years."

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